Saturday, July 25, 2009

Our primary investment focus is on companies that have a history of generating consistent free cash flow. However, Sonic Foundry (SOFO, $0.65) fits within one of our caveats:

Every now and then, we may invest in off-the-run, smaller franchise companies that we believe have sustainable competitive advantages and are trading significantly below the valuation an informed private market buyer would be willing pay for the entire business.

We acknowledge that the stock remains speculative and akin to public venture capital. We call it what it is. We questioned Berkshire Hathaway's BYD purchase the other day, yet -- in fairness -- our SOFO interest could equally be questioned. The short answer is that we continue to believe that the Mediasite franchise is under-appreciated relative to reproduction cost and the valuation that would be assigned by an informed private market buyer. As a reminder, our confidence arises from several competitive advantages that point to a powerful, sustainable franchise: (1) Sonic Foundry/Mediasite is far along the learning curve with (2) intellectual property protection, and (3) very satisfied, captive customers that face high switching and search costs.

Still, we can't hold our breath for a strategic acquirer to purchase the company and, therefore, need to consider Sonic Foundry as a standalone, self-sustaining company. Our thesis needs to be supported by steadily growing revenue and positive cash flow, which is a challenge for most companies in the current environment, let alone a small technology company evangelizing a rich media solution (risky endeavor). Positive earnings and free cash flow are the lifeblood for all companies and the only thing that create tangible value for shareholders.

What do the numbers tell us on a trailing twelve month basis through March? We previously reviewed progress in an earlier post, but again -

Billings of $20.2 million were up 13% Y/Y

Revenue of $18.6% was up 17%

Gross profit of $13.9 million was up 21% (margin expansion)

GAAP operating expenses of $17.3 million were down 15% (expense reduction)

Cash operating income of approximately negative $100 thousand (a $4.7 million Y/Y improvement)

Looking at the balance sheet: deferred revenue at 3/30/09 increased 36% Y/Y to $4.7 million as recurring license and service revenue increasingly contribute to the top-line. Total debt increased slightly to approximately one million from $800 thousand a year ago and net cash declined by $1.5 million to approximately $1.5M (total cash was $2.5 million). We would prefer a larger cash position on which to hang our hat, yet the lower cash balance and modest leverage forces management to remain disciplined on the expense side. After achieving cash break-even operations in the March quarter, the company's primary use of cash going forward should be for working capital assuming fundamentals remain favorable. Sonic Foundry's access to an additional $3 million from Silicon Valley Bank provides headroom to maneuver through the tough economy and to fund working capital related to growth. Capital expenditure requirements are minimal. The below slide from Sonic's F2Q09 presentation summarizes progress toward the break-even inflection point:

Actual results indicate Sonic Foundry is moving in the right direction, yet at a critical juncture - revenue needs to keep scaling with constant costs for the company to generate positive free cash flow.

The hurdle to watch: the business can be self-funding with annualized billings of $21 million (almost there now) and cash generating above $21 million.If Sonic Foundry achieves billings of $21 million in fiscal 2009 (+18% Y/Y) and grows billings 15% to approximately $24 million in fiscal 2010 with constant costs, the company could generate free cash flow of $2 million (working capital is swing factor). Given where the stock trades today, such an outcome would likely surprise many. With potential excess cash, management would probably love to spend additional marketing dollars to build the brand, yet we believe they understand the importance of building cash on the company's balance sheet.

Despite improved operating results over the past year and potential free cash flow on the horizon, why does the stock remain out of favor? We see a handful of reasons: (1) limited cash on balance sheet, (2) illiquid microcap company with small revenue, (3) still limited institutional support (the few professionals able to purchase microcaps may not want to stick their necks out even with favorable fundamentals), (4) concerns surrounding competition and technological change (is Mediasite still number one? or are Adobe's Flash-based solutions making inroads?), and (5) economic concerns surrounding IT spending in the higher education market.

We mostly addressed point (1) above and point (4) in prior posts. Points (2) and (3) can take care of themselves if fundamentals keep moving in the right direction. Point (5) is a tough one. Normally, the June quarter is Sonic Foundry's strongest quarter because of seasonal and fiscal year-end spending by U.S.-based schools ("budget flush" to use up IT budgets before possibly losing funds in next fiscal year). To illustrate, we include the following analysis that shows various figures for the last four June quarters (click to enlarge):

This year, we've gleaned a mixed read as many schools are wrestling with budget woes. A 6/15/09 article from ProAVOnline entitled University AV: Doubling Down in the Downturn included positive as well as negative/mixed commentary from Sean Brown, Sonic Foundry's Vice President of Education:

Positive: 'Hardware and software that allow schools to stream classes over the Web continue to gain acceptance during the recession, says Brown, whose company sells the products. "Our business is increasing right now," he says. "Streaming is a multiplier. It defeats distance, and it's a quality enhancer."'

Negative/mixed: '"[Schools] are cutting and doubling down at the same time," says Sean Brown, vice president of education at Sonic Foundry. "They are reshuffling priorities. The entire pro AV industry needs to be more flexible."'

The good news is that Sonic continues to expand Mediasite usage/adoption and, from our conversations, we know that customers love the product. As a result, Mediasite becomes more entrenched in the daily lives of a growing number of institutions around the world. In addition, the company keeps innovating. To see where the Mediasite platform is headed, we recommend watching minutes 26-41 of the June Mediasite User Group meeting, which provides an overview of Mediasite "version 5.1" -- the user interface appears as follows:

To actually see v5.1 in action, we can watch Sonic Foundry's Sample Unleash 2009 Catalog (link here). Separately, some other Mediasite (v5.0) links to peruse, if interested:

The company's June quarter report this Thursday after market close (Webcast link here) will provide an important progress update. From management, we expect a frank update on the following ten questions:

marketing strategies and ideas to further accelerate Mediasite awareness/adoption

resource constraints/needs, and

competitive landscape and what Sonic Foundry is doing that the competition is not YET doing? (*a favorite question of any company for legend Philip Fisher, author of Common Stocks and Uncommon Profits)

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Common Stock $ense was created by Jeffrey Walkenhorst to periodically share investment ideas and views, and contribute to the community of investors dedicated to fundamental analysis and active portfolio management.Copyright 2009, 2010, 2011.All rights reserved.

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Investment strategies and styles abound today, many of which are focused on short-term, trend trading without regard to the underlying business or its value. At CommonStock$ense, we believe investing in Common Stocks as abusiness ownernot only makesCommon Sense, but can significantly compoundCents into Dollarsover time. Rather than viewing stocks merely as pieces of paper for trading, our approach is to invest as owners of(1) high quality,(2) franchise businessescapable of generating(3) high returns on equityand(4) large, predictable free cash flowthrough economic cycles with(5) limited capital requirementsand(6) capable managementteams. We strive to establish equity positions in such businesses at a(7) substantial discount to our estimate of fair valueby taking advantage of changes in investor sentiment and market volatility, and/or temporary corporate setbacks. Finally, we generally seek companies with(8) limited to no debt.

Two caveats:every now and then, we may invest in (1)off-the-run, smaller franchise companiesthat we believe have sustainable competitive advantages and are trading significantly below the valuation an informed private market buyer would be willing pay for the entire business; and, (2) companies that havevaluable, differentiated physical assetswhere we see ameaningful margin of safetyrelative to normalized asset values.

Our own experience at CommonStock$ense suggests that anowner-oriented investment approachleads topreservation of capitalandfavorable long-term returns, as well assound sleep at night. For helpful reference links, please also see CS$ companion site, The Discriminant Investor.